The Effect of Monetary Policy on Bank Wholesale. Funding

Transcription

1 The Effect of Monetary Policy on Bank Wholesale Funding Dong Beom Choi Hyun-Soo Choi First Draft: July 25, 2015 This Draft: January 5, 2016 Abstract We study how monetary policy affects the funding composition of the banking sector. When monetary tightening reduces the retail deposit supply due to, e.g., a decrease in bank reserves or money demand, banks try to substitute the deposit outflows with more wholesale funding in order to mitigate the policy impact on their lending. Banks have varying degrees of accessibility to wholesale funding sources due to financial frictions, and those who are large banks or already sit on more wholesale funding increase their wholesale funding more. As a result, monetary tightening increases both the reliance on and the concentration of wholesale funding within the banking sector, indicating that monetary tightening could increase systematic risk. Our findings also suggest that introducing liquidity requirements can bolster monetary policy transmission through the bank lending channel by limiting the funding substitution of large banks. The views expressed in this paper are those of the authors and are not necessarily reflective of the views at the Federal Reserve Bank of New York or the Federal Reserve System. We thank Bo Becker, Markus Brunnermeier, Murillo Campello, Harrison Hong, Charles Kahn, William Lang (Discussant), and Don Morgan, as well as the participants of the IAES mini conference on the future of large financial institutions for their helpful comments. We also thank Ulysses Velasquez for research assistance. Any errors are our own. Federal Reserve Bank of New York ( dongbeom.choi@ny.frb.org) Singapore Management University ( hschoi@smu.edu.sg)

2 1. Introduction The recent financial crisis clearly showed the risks of a short-term wholesale funding dependency in banks, critically increasing funding liquidity risks during the market disruption. In response, the Basel Committee on Banking Supervision introduced new liquidity regulations, such as the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR), to contain the excessive reliance on runnable funding in the banking sector. While previous studies have analyzed the risks of the reliance on wholesale funding during the crisis, 1 it remains an open question as to what contributed to the rapid buildup of the banking sector s reliance on wholesale funding running up to the crisis, as well as how the new liquidity regulations would interact with existing policy measures, in particular, monetary policy. In this paper, we examine the impact of monetary policy on bank funding composition, both in the time dimension and in the cross-sectional dimension. We argue that monetary tightening by central banks contributes to the buildup of banking sectors reliance on wholesale funding, as well as systemic imbalances. The distribution of the reliance on wholesale funding becomes more concentrated among heavy users or large banks. This implies that a financial system could become more vulnerable during monetary tightening in terms of funding liquidity risks and potential spillover effects (e.g., fire-sale externalities that are increasing in the bank asset size). We then discuss the implications of the interaction between the new liquidity regulations and monetary policy, both in terms of systemic stability (focusing on risks) and the monetary policy transmission mechanism (focusing on policy effectiveness). Bank borrowing can typically be divided into two sources, retail deposits and wholesale funding. Retail deposits, sometimes referred to as core deposits or core funding, represent funding from a bank s traditional and regular customer base in the local geographic market. In contrast, wholesale funding is mostly supplied by other financial intermediaries, such as 1 See, e.g., Gorton and Metrick (2012), Copeland et al. (2014), and Krishnamurthy et al. (2014) on the risks of Repo funding; Cornett et al. (2011), Ivashina and Scharfstein (2010), De Haas and Van Lelyveld (2014), and Dagher and Kazimov (2015) on the wholesale funding reliance and bank lending during the crisis; and Irani and Meisenzahl (2015) on the bank liquidity risks from the wholesale funding reliance and secondary market liquidation. 1

3 money market mutual funds, and raised through the money market (e.g., large certificates of deposit, foreign or brokered deposits, and repo funding). Retail deposits are cheaper in terms of funding costs (Berlin and Mester (1999), DeYoung and Rice (2004)), have lower interest rate-elasticity (Amel and Hannan (1999)) owing to transactional or storage (i.e., monetary ) purposes of depositors, and are more sticky with regard to funding liquidity risks and sensitivity to financial markets conditions (Flannery and James (1984), Berlin and Mester (1999), Cornett et al. (2011)). Because the retail deposit supply is highly price-inelastic, banks often reach out to the wholesale funding markets when they wish to expand their lending. We first discuss the relationship between changes in monetary policy stances and the growth of wholesale funding reliance in the banking sector, where we measure the wholesale funding reliance of a bank as the ratio of total wholesale funding to retail deposits. Previous studies widely suggest that monetary tightening drains retail deposits from the banking sector (e.g., Bernanke and Blinder (1992); Kashyap and Stein (1995)) by decreasing bank reserves, and by raising the opportunity cost of holding such bank money, which pays upwardsticky interest, if any at all (Hannan and Berger (1991), Drechsler et al. (2015)). Facing the deposit outflows, banks increase their reliance on alternative funding sources, such as wholesale funding, in order to smooth their lending. Using quarterly panel data from the Consolidated Financial Statements for Holding Companies ( FR-Y9C ) and the Federal Reserve s Report of Condition and Income ( Call Reports ) between 1992 and 2006, we find that changes in banks reliance on wholesale funding are positively associated with changes in the federal funds rate. Monetary tightening does decrease banks retail deposits and increase wholesale funding. Next, we analyze the cross-sectional implications of this funding substitution during monetary tightening. Using a simple model, we argue that banks facing fewer financial frictions in the wholesale funding market, in equilibrium, choose to use more wholesale funding and become larger. In response to monetary tightening, which causes retail deposit outflows to 2

4 squeeze lending, the banks increase their wholesale funding until the marginal cost of the funding is equal to the marginal product from lending. This implies that banks that are already large and sit on more wholesale funding add more wholesale funding, because they face a less elastic supply curve (i.e., the funding cost increases less rapidly as they increase their wholesale borrowing) due to the fewer financial frictions. As a result, the overall reliance on wholesale funding of the banking sector increases, and the increase is more pronounced in larger banks. The cross-sectional difference of the wholesale funding reliance would also increase rapidly during monetary tightening, because the heavier wholesale borrowers would add more wholesale borrowing. Our empirical analysis supports this prediction. When the policy rate increases, the funding substitution is more active for banks with greater assets, and banks with a greater reliance on wholesale funding experience larger changes in their reliance. Thus, wholesale funding in the financial system become more concentrated among such banks during monetary tightening. In addition to the change in bank funding composition, our model indicates that banks with more active funding substitution would be less affected by the lending channel. Defining the sensitivity of funding substitution to monetary policy as the correlation between the change in the federal funds rate and the change in wholesale funding reliance, we find that monetary policy has less impact on the lending of banks with a higher funding substitution sensitivity. Our empirical specifications, regressing bank-level balance sheet adjustments on changes in the monetary policy stance, could have an identification problem if our regression confounds the changes in bank loan demand. In order to mitigate this problem, we incorporate various controls that reflect loan demand in our main specification, including both macro and banklevel variables. In addition, we implement a robustness check that limits our sample to local banks that operate predominantly within a single MSA, with MSA-level controls reflecting local demand. In addition, we take advantage of demographic variations (among senior and nonsenior bank customers) across regions. We argue that the deposit supply of seniors, who 3

5 should use bank deposit accounts primarily for storage purposes, would be less sensitive to a change in the policy rate than that of non-seniors, who should have more saving or investment incentives. 2 Therefore, banks facing a younger deposit base should experience greater retail deposit outflows during monetary tightening and, thus, increase their wholesale funding by relatively more than in other banks. We estimate the fraction of seniors a local bank would face in local markets using the FDIC Summary of Deposits and Census, and verify that our prediction holds using the bank-level depositor demographic variable. We furthermore compare large and small local banks within the age demographic groups, using the demographic variations across regions. Here, we identify more clearly whether banks facing a young deposit base have more willing to reach out to wholesale funding, because of greater funding outflows, rather than responding passively to the demand change. When examining the scale of the funding substitution across banks, we should observe greater crosssectional differences by asset size, if these banks are more willing to borrow but are financially constrained. However, we should see smaller differences if the greater retail deposit decrease is caused by a greater decline in local demand financial frictions would then matter less in this case. We find that large local banks with a younger deposit-base engage in more active funding substitution than their smaller counterparts. However, this is not the case for banks with an older deposit-base. Thus, this result supports the effect of monetary policy on retail deposit supply and the funding composition response, rather than the effect through the local demand change. This relationship between the bank funding composition and monetary policy suggests several novel policy implications. First, systemic vulnerability could increase when central banks try to contain excessive credit growth by implementing monetary tightening. In their attempt to unwind the tightening effect by the lending channel, banks might increase their reliance on highly runnable funding sources. This is more pronounced in systemic banks, which are larger and more exposed to liquidity risks, amplifying potential externalities on the 2 We use this demographic structure as a measure of the deposit supply sensitivity to monetary policy changes, instead of as a measure of the deposit supply level, as in Becker (2007). 4

6 entire system. In this case, the liquidity requirements could promote financial stability by imposing additional costs on the substitution of retail deposits with wholesale funding, which would prevent the surge in wholesale funding reliance and funding liquidity risks. Therefore, our study provides a novel perspective on the importance of the interaction between monetary policy and macroprudential regulations. Furthermore, our results suggests that monetary policy transmission on real output could become more effective through a bolstered bank lending channel when combined with liquidity regulation. Since regulatory liquidity requirements are more binding for large banks, which usually rely more on wholesale funding, and thus, have a lower LCR, the implicit substitution cost of the two funding sources would be higher for large banks. This contrasts with the findings in the bank lending literature, in which large banks can easily smooth their lending through better accessibility to alternative funding sources (Kashyap and Stein (2000), Kishan and Opiela (2000)), mitigating any aggregate effect through the lending channel (Romer and Romer (1990)). Since large banks with binding liquidity requirements would reduce their lending in response to monetary tightening, this could decrease the aggregate bank credit. In order to validate this argument, we build a proxy for the LCR ( Liquidity Ratio ) based on publicly available data (FR-Y9C). Our analysis indicates that, historically, (i) larger banks have lower liquidity ratios, and (ii) changes in the liquidity ratio are negatively associated with federal fund rate changes. In summary, liquidity requirements would be more binding during monetary tightening, particularly for large banks. Related Literature This study is related to several strands of literature. The bank lending channel literature (e.g., Bernanke and Blinder (1992); Kashyap and Stein (1995); Peek and Rosengren (1995); Kashyap and Stein (2000)) analyzes how bank lending responds to monetary policy changes, but most of the empirical analyses focus on the asset side. Instead, we focus on the liability composition and on liquidity implications, with novel predictions. Previous studies examine the risks for banks of wholesale funding, particularly the impact 5

7 of wholesale funding reliance during financial crises (see, e.g., Shin (2009); Gorton and Metrick (2012); Copeland et al. (2014); Krishnamurthy et al. (2014); Cornett et al. (2011); Ivashina and Scharfstein (2010); De Haas and Van Lelyveld (2014); Dagher and Kazimov (2015); Irani and Meisenzahl (2015)). However, the reasons for this increase in banks reliance on wholesale funding remains an open question. Here, we present one possible channel through which wholesale funding in the banking sector grows and becomes concentrated among banks with greater externalities. Acharya and Mora (2015) and Egan et al. (2015) examine the substitution between core and non-core funding during bank stress when wholesale funding flows out, and Hahm et al. (2013) study the relation between non-core funding reliance and financial stability. This study is also related to the literature analyzing the effect of monetary policy on financial stability, and that on the interaction between monetary policy and macroprudential regulation. There is emerging literature on the risk taking channel of monetary policy (for an overview, see Borio and Zhu, 2012; De Nicolò et al., 2010; Adrian and Shin, 2010), in which monetary loosening leads to lax lending standards and excessive risk taking (see, e.g., Jiménez et al. (2014); Ioannidou et al. (2009); Peydró and Maddaloni (2011); Dell Ariccia et al. (2013)). Adrian and Shin (2008, 2009) and Dell Ariccia et al. (2014) analyze the role of monetary policy on financial stability via changes in financial sector leverage, and Allen and Gale (2004) discuss how monetary loosening can lead to an asset price bubble. While these studies focus on financial vulnerabilities increasing during monetary loosening, we focus on the systemic imbalance that could form if central banks try to contain the aforementioned vulnerabilities through monetary tightening. Landier et al. (2015) examine the asset substitution problem, which is exacerbated during tightening, while we focus on the funding side. Maddaloni and Peydro (2013), Stein (2012), and Bech and Keister (2013) examine the interaction between monetary policy and macroprudential regulations, and Kashyap et al. (2014) investigate macroprudential regulation and credit supply. 6

8 The remainder of this paper is organized as follows. Section 2 discusses our theoretical argument and develops our empirical hypotheses. Section 3 explains our data and presents the empirical results. Section 4 discusses the implications of the interaction between monetary policy and liquidity regulation, based on our results. Finally, Section 5 concludes the paper. 2. Theory In this section, we discuss how monetary tightening affects the retail deposit supply to the banking sector, bank funding composition, and bank liquidity ratios (e.g., LCR) Retail deposit supply and monetary policy Panel A of Figure 1 plots the relationship between the year-on-year percentage changes of total checkable deposits 3 from the Federal Reserve Board s Money Stock Measures data and the federal funds rates. There exists a clear negative relationship between the two time series; checkable deposits in the banking sector tend to decrease during monetary tightening when the federal funds rate is increasing. In our model, we assume this negative relationship between the retail deposit supply and the policy rate as given exogenously, without attempting to explain the mechanism, which is widely documented in the literature (e.g., Bernanke and Blinder 1992; Kashyap and Stein 1995). Here, we briefly enumerate some of the channels through which monetary tightening drains retail deposits from the banking sector. 1. Decrease in central bank reserves Monetary tightening reduces the central bank reserves through open market operations. This limits the amount of reservable deposits (mostly retail deposits) that banks can issue, owing to the reserve requirement or liquidity concerns, and leads to less money creation by banks (see, e.g., Bernanke and Blinder (1992), Kashyap and Stein (1995), and Bianchi and Bigio (2014)). 3 This is a proxy for the retail deposits. Our definition of retail deposits is more comprehensive, including small time deposits. See Section 3 for our variable definitions. 7

9 2. Decrease in money demand Retail depositors save in banks primarily for monetary purposes, such as transactions or storage, incurring the cost of a low interest payment. Money demand derives from the agent s portfolio decision between liquid and illiquid assets (Baumol (1952); Tobin (1956)). The demand for money decreases when the policy rate increases, because the opportunity cost of holding money increases. Therefore, the demand for bank money also decreases during tightening, 4 which shifts the supply curve of retail deposits to the banking sector upward (Bernanke and Blinder (1988)). 3. Substitution to alternative money-like assets (e.g., MMFs) The previous channel focuses on switching from a money-like asset to more illiquid non-money assets (a decrease in money demand). In addition, financial innovation has introduced alternative money-like assets, which led to a substitution between different private monies. For instance, although relatively less convenient and less liquid than bank deposits, money market funds (MMFs) offer such money-like services, and provide higher yields than bank deposits. 5 Panel B of Figure 1 shows a negative relationship between MMF asset growth and checkable deposit growth, especially after the 1990s, when MMFs became popular. Because MMFs offer more market-competitive yields than do retail deposits, the yield spread between MMFs and bank deposits increases when the policy rate increases. This creates a substitution within moneylike assets; funds are reallocated from retail deposits to MMFs during tightening, shifting the supply curve of retail deposits to the banking sector upward. 6 4 Though some retail deposits bear small amount of interests, their rates do not respond quickly to monetary tightening. See, e.g., Hannan and Berger (1991) and Drechsler et al. (2015) on deposit rate upward stickiness. One rationale for this upward stickiness could come from the very short maturity of retail deposits; if a bank decides to raise its deposit rate to retain more deposits on the margin, it would have to apply this higher rate to all (checkable, with no maturity) deposits, which significantly inflates the overall funding cost. Therefore, it could be cheaper for the banks to reach out to alternative funding sources than to raise the deposit rates, in the event of marginal changes in the deposit supply. 5 Historically, MMFs were created as a substitute for bank deposits in the 1970s when deposit interest payments were restricted by Regulation Q, and started to grow rapidly in the 1990s. The aggregate asset size of the MMFs in the United States grew from around 0.4 trillion in 1990 to almost 2 trillion by the end of Note that some of these retail deposit outflows to MMFs re-enter the banking sector as wholesale funding, because MMFs are one of the main suppliers of bank wholesale funding. 8

10 2.2. Model: Bank funding and liquidity implications We build a simple static model to solve for the optimal bank portfolio problem, given a policy rate. We then analyze the bank responses to deposit outflows caused by monetary tightening, and develop empirical hypotheses. Our interests lie in the funding composition of banks (i.e., retail versus wholesale funding), as well as in the liquidity ratios of banks that measure the liquidity mismatch of their balance sheets (e.g., LCR). We consider two risk-neutral banks, Bank 1 and Bank 2, who face identical functional forms of retail deposit supply and loan demand, for simplicity. Given a loan demand schedule, a bank finances its assets from two sources of funding, 7 retail deposits and wholesale funding. We assume that retail deposits only reflect the money demand of depositors and are noninterest bearing, 8 and that their cost is negligible for the banks. Furthermore, the supply of retail deposits banks face is exogenous and decreasing in the policy rate r, as discussed in the previous section, is denoted by M(r), with M (r) < 0, and is identical across the two banks. Let M i be the amount of retail deposits that Bank i (where i = 1, 2) chooses to attract. The only difference between the two banks is the cost incurred when attracting wholesale funding (reflecting heterogeneous accessibility to money markets). Due to financial frictions, such as agency problems, the borrowing cost of wholesale funds increases in the size of the total borrowing. Let the marginal cost of wholesale funding for Bank i(= 1, 2) be MC i (Q i ) = c i +d i Q i, where Q i is the amount of total wholesale funding for Bank i. We assume c 2 > c 1 > 0 and d 2 > d 1 > 0, such that wholesale funding is more costly for Bank 2, which faces a more inelastic supply curve, implying greater financial frictions. Using their funding M i + Q i, the banks can either issue loans, denoted by L i, or hold the funding as reserves R i, such that M i +Q i = L i +R i. We assume that all banks are monopolists in their own loan markets, and face a downward sloping loan demand curve D(L i ), which is 7 We do not consider equity issuances, for simplicity. 8 Alternatively, we could assume that the supply is highly inelastic to the interest rate offered by banks. 9

11 identical for both banks. We denote the marginal product of lending as MP (L i ) = a bl i. 9 In short, both banks face similar degrees of competition in the lending and retail deposit markets. The only notable difference is the financial frictions each bank faces in the wholesale funding markets. Reserves do not generate a return, but the banks are subject to reserve requirements, such that R i δm i with 0 < δ < 1. We now solve for the optimal bank portfolio decision (Mi, Q i, L i, Ri ) to maximize their profits, given the initial policy rate r = r 0. Since the retail deposit supply is perfectly inelastic with no cost, banks exploit retail deposits for lending before reaching out for wholesale funding, such that M i = M(r 0 ). Banks also hold minimum reserves to meet the reserve requirements, such that Ri = δmi. After lending out all their retail deposits, banks use wholesale funding until the marginal product of lending is equal to the marginal cost of wholesale funding, such that MC i (Q i ) = MP (L i ), where total lending is equal to L i = Q i + (1 δ)mi. Solving this, we have Q i = a c i b(1 δ)m i b + d i. Thus, we obtain the following proposition comparing the two banks, suggesting that banks facing fewer financial frictions borrow more wholesale funding and become larger. Proposition 1. Q 1 > Q 2, and L 1 > L 2. We define Bank i s wholesale funding reliance ( W F R i ) as the ratio between wholesale funding and retail deposits (i.e., W F R i = Q i ). We also define a liquidity ratio for the Mi banks, measuring the liquidity mismatch risks, in order to reflect statutory liquidity measures such as the LCR or NSFR. We calculate the liquidity ratio by dividing aggregate liquidityadjusted assets by aggregate liquidity-adjusted liabilities. More specifically, the liquidity ratio 9 Both a and b are positive, and we assume that a is large enough that banks use both funding sources in equilibrium. 10

12 ( LR ) is defined as LR i = α RR i + α L L i β M M i + β Q Q i, where α R > α L and β M < β Q, implying that reserves are more liquid than loans and retail deposits are stickier than wholesale funding, as per Basel III assumptions. We also assume α L < β M, reflecting the liquidity transformation of a bank. A higher value of LR implies less liquidity risk exposure. Thus, we obtain the following corollary, comparing the wholesale funding reliance and the liquidity ratios of the two banks. Corollary 1. W F R 1 > W F R 2 and LR 1 < LR 2. From Corollary 1, we obtain the following empirical prediction. Prediction 1. Larger banks rely more on wholesale funding, and their (statutory) liquidity ratios are lower. Now, suppose the central bank tightens monetary policy, such that the new policy rate is r 1 (> r 0 ). For simplicity, we assume that this does not affect loan demand D(L), so that we focus explicitly on the bank lending channel. 10 We also assume, for simplicity, that the cost of wholesale funding is not affected by the policy changes. 11 Monetary tightening shifts the retail deposit supply curve to the left, and the banks can attract retail deposits only up to M i = M(r 1 ), which is less than M i. Consequently, the banks would need to reduce their lending by (1 δ)(mi Mi ) = (1 δ)(m(r 0 ) M(r 1 )). In order to maintain their lending, they borrow additional wholesale funding until the marginal cost 10 This assumption shuts down the interest-rate channel of monetary policy, through which interest rate changes directly affect demand. A weaker assumption we need is that the response of loan demand to monetary policy is more sluggish than the response of the retail deposit supply. 11 If monetary tightening significantly increased the wholesale funding cost, banks would decrease their wholesale funding, which is the opposite of our prediction. Note that we would have the same empirical predictions, even when the costs of wholesale funding increase (e.g., both c 1 and c 2 increase by the same amount), while the increase is not so large that it leads to a decrease in wholesale borrowing. 11

13 of borrowing and the marginal product of lending are equalized. That is, bank i s wholesale funding increases from Q i to Q i comparing the two banks. = a c i b(1 δ)mi b+d i, and we now have the following proposition Proposition 2. Q 2 Q 2 < Q 1 Q 1 and L 2 L 2 < L 1 L 1 < 0. This proposition implies that banks with better access to wholesale funding can better mitigate the policy shock and smooth lending, which is in line with the argument in the bank lending channel literature (e.g., Kashyap and Stein, 2000; Kishan and Opiela, 2000). We now obtain the following prediction with regard to the bank funding composition. Prediction 2. During monetary tightening, (i) banks increase their reliance on wholesale funding, (ii) which is more pronounced if they face fewer financial frictions in the funding markets, and (iii) banks could better mitigate the monetary policy impact on lending by implementing such funding substitution more actively. Note that the banks that add more wholesale funding (larger Q i Q i ) are those with relatively large wholesale funding usage prior to the policy change (larger Q i ) and with a larger asset size. In our model, the retail deposit outflows, which occur when the policy rate increases, are exogenous (e.g., due to depositors preferences) and are not bank-type specific. However, banks face heterogeneous costs when substituting these funding outflows with wholesale funding. Thus, some banks experience a more rapid increase in their funding costs as they increase wholesale borrowing. Thus, they add less wholesale funding than do banks whose funding cost increases slowly. Note that these are the banks who choose to borrow less wholesale funds, even under the old policy rate r 0, owing to those financial frictions. We now have the following prediction on the concentration of wholesale funding in the banking sector. 12

14 Prediction 3. During monetary tightening, banks that rely more heavily on wholesale funding and/or are larger become more reliant on wholesale funding. In other words, wholesale funding becomes more concentrated in the banking sector, increasing systemic imbalances. Suppose that the private and social costs of wholesale funding deviate, because, for example, individual banks do not consider pecuniary externalities through a fire-sale of assets (e.g., Lorenzoni (2008), Stein (2012))), which becomes more likely as the reliance on wholesale funding increases. This wedge should be greater for larger banks, because they impose more externalities on others during the fire-sale episodes. Our prediction indicates that this distortion would become greater during monetary tightening as the larger banks add more wholesale funds, which increases their exposure to liquidity risks. We now discuss the impact of liquidity requirements on the bank lending channel. With the funding substitution, the liquidity ratios of the banks decrease during monetary tightening owing to an increase in the reliance on flighty wholesale funding and a decrease in liquid reserves. When the introduction of new liquidity requirements imposes a mandatory lower bound on the liquidity ratio, this constraint becomes more binding during the tightening period. In addition, the constraint would be more binding for the larger bank (Bank 1), because its liquidity ratio is lower. In this case, because the larger banks cannot easily substitute their deposit outflows with wholesale funding to smooth their lending, we have the following prediction. Prediction 4. Liquidity requirements become more binding in the monetary tightening regime, particularly for larger banks. Compared with an economy without such requirements, larger banks would reduce their lending by relatively more in response to monetary tightening. This implies that monetary tightening could have a greater effect on the lending of larger banks with the introduction of liquidity requirements, because these requirements increase the 13

15 implicit cost of the funding substitution from retail to wholesale funding. In other words, we expect more effective monetary policy transmission on aggregate lending through a greater effect on the larger banks. This contrasts with the prediction of the conventional lending channel literature, in which only small banks with limited access to alternative funding sources are affected, leading to a non-significant aggregate effect (Romer and Romer (1990)). 3. Empirical Results 3.1. Data We collect quarterly data from the Consolidated Financial Statements for Holding Companies ( FR-Y9C ) and the Federal Reserve s Report of Condition and Income ( Call Reports ) from 1990:I to 2014:IV in order to construct the bank-quarter variables. If a bank fulfills the FR-Y9C s reporting criteria, we use bank holding company (BHC)-level variables directly from the FR-Y9C. For banks that do not file an FR-Y9C, but that have the Call Report item RSSD9348 (RSSD ID of the top holder) populated, we aggregate the bank-level variables by RSSD9348 as the BHC-level variables. For banks that do not file an FR-Y9C and do not have the RSSD9348 field populated, we use their Call Report data, and interpret these as stand-alone commercial banks. We refer to both BHCs and commercial banks as banks, for simplicity. For each quarter, our sample consists of 4,871 banks, on average. 12 We construct variables for bank funding composition in the following way. RD is the amount of bank retail deposits, calculated by subtracting wholesale deposits (brokered and foreign deposits, as well as large time deposits beyond $100,000) from total deposits. WSF is a bank s total wholesale funding, which is the sum of wholesale deposits, fed funds, repo borrowing, and other borrowed money. We then construct the wholesale funding to retail deposit ratio (WSF to RD = WSF / RD), which is our main measure of a bank s reliance on 12 We drop bank-quarter samples if the bank had more than a 50% change in total assets during a quarter, following Campello (2002). We only include banks with all control variables. 14

16 wholesale funding. We winsorize all variables at the 1% and 99% levels, by quarter. We measure changes in the monetary policy stance using the quarterly changes in the effective federal funds rate (FFR), retrieving data from the Board of Governors of the Federal Reserve System. We drop years after the recent financial crisis, owing to the lack of variation in the FFR. We also drop the crisis years, starting in 2007, when the wholesale funding supply dried up for reasons other than monetary policy. Thus, our sample period is from 1992 to Summary statistics Table 1 reports the summary statistics of variables in our analysis. Bank retail deposits (RD) have a mean of 253 million dollars and a standard deviation of 842 million dollars. The distribution of retail deposits is right-skewed (skewness of 6.93). The bank with the least amount of retail deposits has 6 million dollars in retail deposits, whereas the bank with the most retail deposits has 9.5 billion dollars in retail deposits. Bank wholesale funding (WSF) has a mean of 100 million dollars and a standard deviation of 466 million dollars. The distribution of wholesale funding is also right-skewed (skewness of 8.86). The bank with the least amount of wholesale funding has 0.1 million dollars in wholesale funding, whereas the bank with the most wholesale funding has 7.4 billion dollars in wholesale funding. The ratio of wholesale funding to retail deposits (WSF to RD) has a mean of 24% and a standard deviation of 24%. The distribution of WSF to RD is less skewed (skewness of 3.34) than is WSF or RD, because we are controlling for common factors that affect the skewness of RD and WSF by taking the ratio. We are interested in the change in bank funding composition. The % Change in RD is the quarterly percentage change in a bank s RD; this has a mean of 2% and a standard deviation of 5%. The % Change in WSF is the quarterly percentage change in a bank s WSF; this has a mean of 5% and a standard deviation of 20%. The % Change in (WSF + RD) is the 13 In our analysis, we control for bank-level and aggregate-level year-to-year loan growth with a four-quarter lag. Thus, our sample starts from

17 quarterly percentage change in a bank s total funding, the sum of wholesale funding and retail deposits; this has a mean of 2% and a standard deviation of 5%. The Change in WSF to RD is the quarterly change in a bank s WSF to RD ratio; this has a mean of 0.4% and a standard deviation of 5%. Although we include bank fixed effects in our analysis to control for time-invariant characteristics, we also control for additional lagged bank characteristics. log Assets is the log of a bank s total assets; Capital Ratio is the ratio of a bank s total equity to total assets; 14 ; Liability Interest Rate is the ratio of total interest expenses to average total liabilities; Liquid Asset Ratio is the ratio of liquid assets (sum of cash, fed funds lending and reverse repo, and securities holding) to bank assets; RE Loan to Total Loan Ratio is the ratio of real estate loans to total loans; CI Loan to Total Loan Ratio is the ratio of CI loans to total loans; Bank-level Total Loan Growth is the year-to-year growth rate of total bank lending; and Aggregate-level Total Loan Growth is the year-to-year growth rate of aggregate lending by all banks Wholesale funding reliance and liquidity ratio by asset size We empirically test the predictions from our model. First, from Prediction 1, we expect that wholesale funding reliance is greater and the liquidity ratio is lower for large banks than it is for small banks. Figure 2 shows the correlation between WSF to RD and log Assets, and between Liquid Asset Ratio and log Assets of the banks in our sample. We take the time-series average of WSF to RD, Liquid Asset Ratio, and log Assets by bank from 1992 to Here, we find a strong positive relationship, with a t-statistic of between log Assets and WSF to RD. We also find a strong negative relationship, with a t-statistic of , between log Assets and the Liquid Asset Ratio. This confirms that, in general, larger banks rely more on wholesale funding and hold less liquid assets. 14 We compute asset-weighted top holder-level capital ratios from bank-level capital ratios if the top holder does not file a Y-9C. 16

18 3.4. Change in bank funding composition We next estimate the responses of bank funding composition to changes in the monetary policy stance. From Prediction 2, we expect that during monetary tightening (loosening), (i) banks retail deposits would decrease (increase), (ii) banks wholesale funding would increase (decrease), (iii) as a result, the banks would increase (decrease) their overall reliance on wholesale funding, and (iv) banks facing fewer financial frictions in the markets for borrowed money would experience greater change in their funding composition. Figure 3 shows the time series of WSF to RD, our measure of wholesale funding reliance, along with the fed funds rate from 1990 to Panel A reports the aggregate WSF to RD ratio, which is a ratio of aggregate wholesale funding to aggregate retail deposits, using FR Y-9C. Note that there was a general upward trend in the reliance on wholesale funding running up to the recent financial crisis, but that in 2014, it fell to the 1996 level. The period showed a slight drop in wholesale funding reliance, which coincides with the period of declining interest rates. Overall, we can observe a positive association between the policy rate and the wholesale funding reliance of the banking sector. Panel B reports the average WSF to RD ratio using bank-level WSF to RD. This is quite similar to the aggregate trend, but the general levels are lower, and we no longer see the dip in The unweighted average of WSF to RD in this Panel puts less weight on the larger banks (who are also likely to have high WSF to RD) and more weight on the smaller banks (who are likely to have low WSF to RD) than in Panel A. Thus, a comparison of the two panels indicates that the general level and the variation of the wholesale funding reliance are greater for the large banks (with high WSF to RD) Baseline result Table 2 reports the panel regressions of the changes in bank funding composition on the changes in the federal funds rate (FFR). We use a distributed-lag model to incorporate the lagged FFR effect on a bank s funding composition (i.e., Kashyap and Stein (2000)). We 17

19 control for bank fixed-effects and quarter fixed-effects. In addition, we control for other bank characteristics, as of a year ago, to mitigate simultaneity problems, including the RE Loan to Total Loan Ratio, CI Loan to Total Loan Ratio, log Assets, Capital Ratio, Liability Interest Rate, and Liquid Asset Ratio. We further include Bank-level Total Loan Growth and Aggregate-level Total Loan Growth as controls for the changes in loan demand. Column (1) reports the regression result of the changes in bank retail deposits on the changes in FFR. The four lags of quarterly changes in FFR are our main independent variables. The sum of the effects from the four lags of FFR changes is , with a t-statistic of , where standard errors are clustered by bank. That is, an increase in FFR decreases a bank s retail deposits, and this relationship is statistically significant. Column (2) reports the regression result of the changes in bank wholesale funding usage on the changes in FFR, using the same controls as in column (1). We find that there is a statistically significant, positive change in the wholesale funding amount when the FFR increases. Column (3) reports the regression result of the changes in bank total borrowing on the changes in FFR, where total borrowing includes both wholesale funding and retail deposits. We find a statistically significant reduction in the total borrowing of a bank when the FFR increases. Note that the increase in wholesale funding only partially offsets the reduction in retail deposits, suggesting a decrease in funding for lending. 15 Column (4) reports the regression result of the changes in bank wholesale funding reliance measured by WSF to RD on the changes in FFR, which is our main focus. We find a statistically significant increase in the wholesale funding reliance with increasing FFR, as expected. The opposite happens when the FFR decreases. This result comes directly from columns (1) and (2): RD decreases and WSF increases with FFR. Table 3 reports the same regressions as in Table 2, but by different bank asset size groups. As in the lending channel literature, we implicitly assume that the larger banks face fewer financial frictions in their funding markets. From Prediction 2, we thus expect to find greater 15 However, this effect could be mitigated if a bank reduces its liquid assets holding for more lending, as in, for example, Kashyap and Stein (2000). 18

20 substitution in funding in larger banks than in smaller banks. Following Kashyap and Stein (2000), we define a bank as small if the asset size of the bank is below the 95th percentile in the asset distribution of banks in the quarter; as medium if the asset size is within the 95th percentile and 99th percentile; and as large if the asset size is above the 99th percentile. In our sample, there are 4,566 small banks, 183 medium banks, and 122 large banks. Columns (1) (3) report the estimation results of changes in the bank retail deposits, by bank size, on the changes in FFR. Column (1) comprises small banks, column (2) comprises medium banks, and column (3) comprises large banks. All three groups show statistically significant reductions in their retail deposits when the FFR increases. Note that the scale of the estimated effects is similar across the three groups, suggesting that banks experience similar fractions of retail deposit outflows during monetary tightening, irrespective of their size. Columns (4) (6) report the results of changes in bank wholesale funding usage, by bank size, on the change in the FFR. We find a statistically significant increase in wholesale funding usage in all groups. Small banks show large increases owing to the initial low wholesale funding amount. 16 Columns (7) (9) report the regression results of the changes in banks reliance on wholesale funding on the change in the FFR. We find statistically significant increases in the wholesale funding reliance in all bank groups. The numbers in the columns are more comparable, because we are controlling for relative size differences using ratios. Note that the larger banks experience a greater change in their wholesale funding reliance, as predicted in Prediction Potential endogeneity due to the loan demand effect One of our main identification problems is that changes in bank loan demand could have a confounding effect. For instance, a positive relationship between the wholesale funding reliance of a bank and a change in the FFR could emerge, not through the policy impact, 16 When we use the percentage change in wholesale funding to total asset as dependent variable instead of using the percentage change in wholesale funding itself, we find a stronger increase in wholesale funding in large banks than in small banks. 19

21 but through the change in local loan demand. With increasing borrowing demand, banks are willing to use more wholesale funding to meet the demand while the central bank decides to tighten monetary policy, simply responding to this credit boom. 17 Cross-sectional results could also be driven by different loan demand faced by banks. To mitigate the impact of potential changes in loan demand, we control for bank-level total loan growth and aggregate-level loan growth in our baseline regression. We further implement the following robustness analyses of our results. We control for MSA characteristics such as population, income per capita, and unemployment rate in order to capture the local business cycle. We limit our sample to local banks that operate mainly in a single MSA, so that our MSA-level controls better capture the economic environment a bank is facing. We define a bank as local if it collects more than 80% of its deposits from one MSA, and assign the MSA with the most deposits as the primary market of that bank. Table 4 reports the regression results using local banks only and controlling for MSA characteristics. We find that these MSA variables indeed reflect the local business cycle: higher income is positively associated with retail deposits, wholesale funding, and the wholesale funding to retail deposit ratio, whereas a lower unemployment rate presents the opposite association. However, our main results are unaffected Differentiating monetary policy impact using local age demographics Using our samples of the local banks, we further implement the following analysis, exploiting the demographic variation across regions. Becker (2007) suggests that areas populated with more seniors tend to have more deposits in banks, and uses this demographic characteristic as an instrument for deposit supply level to the banking sector. We instead use this regional demographic variation as a measure of deposit supply sensitivity to monetary policy, driven 17 In the context of our model in Section 2, this would correspond to the upward shift in loan demand (i.e., MP (L i )), which increases the wholesale funding reliance in equilibrium. However, monetary tightening usually shifts the loan demand downward (so called interest-rate channel of monetary policy), which would go against our empirical predictions. Thus, it is when the timing of monetary tightening coincides with very strong growth in loan demand that could bias our estimation results. 20

22 by the different motivations among the old and young generations for parking money in bank deposit accounts. Seniors, who mainly consume their accumulated savings as retirees, use bank deposit accounts primarily for storage purposes. Non-seniors are more sensitive to saving or investment incentives. Therefore, non-seniors are more yield-sensitive, and given the upward stickiness of the deposit interest rate, the deposit supply by non-seniors to the banks would decrease more in response to an increase in the policy rate (i.e., M(r) in our model of Section 2 is steeper for non-seniors). Hence, banks whose deposit-base in the local market consists mostly of non-seniors would experience more deposit outflows during monetary tightening, and so more actively increase their reliance on wholesale funding. Based on the Census annual population estimate, we first compute the fraction of the population older than 65 for all US counties. Using the Summary of Deposit data on banks branch-level deposit distributions, we then compute the deposit-weighted fraction of the old population for each bank. This is a proxy for the fraction of seniors that a bank would face in its local market. To better capture the demographic characteristics of deposit-base across banks, we focus only on local banks that collect most of their deposits from a single MSA. 18 We then sort banks by the bank level time-series average of this measure and define a Young Deposit-Base dummy, indicating that the bank is below the median. 19 We first test whether the banks facing a younger deposit-base experience a larger retail deposit outflow when monetary policy tightens. Table 5 reports the estimation results. We interact the Young Deposit-Base dummy with the changes in the FFR to test the difference in the policy effect between banks with a younger deposit-base and those with an older depositbase. As in our baseline results, we find that an increase in the FFR decreases a bank s retail deposits, increases a bank s wholesale funding usage, and increases a bank s reliance on 18 Note that two local banks operating in the same MSA may face different levels of an elderly population, because we construct our measure from a more granular county-level composition, and weight-average it with county-level deposit amounts. 19 County-level age demographics are highly persistent. We can use the annual measure of the elderly fraction instead, but this creates a discrete change in the Young Deposit-Base dummy, even with minor changes in the elderly population. The results based on the annual measure are similar. 21

23 wholesale funding. When we interact the change in the FFR with the Young Deposit-Base dummy, for banks facing younger deposit-base in their local deposit markets, we find a larger decrease in a bank s retail deposit, a larger increase in a bank s wholesale funding usage, and a larger increase in the bank s wholesale funding reliance. This indicates that a monetary policy shock on banks retail deposit outflows differs by area and demographics of banks deposit-base. Greater retail deposit outflows are associated with a larger increase in wholesale funding usage, resulting in a greater reliance on wholesale funding, as predicted. However, this difference could still be a product of difference in omitted characteristics (e.g., business cycle sensitivity) between the two age-regional groups, and does not necessarily imply that banks with a younger deposit-base engage in more active funding substitution to reverse the greater funding outflow shock. For instance, greater retail deposit outflows of banks with younger deposit-base could reflect a decline in local demand rather than a policy shock on the deposit supply. In order to show that the decrease of the retail deposit supply during monetary tightening leads to funding substitution, we examine whether financial frictions matter more for banks facing a young deposit-base (i.e., they have more willingness to reach out to wholesale funding). If the decrease in local demand contributed to the retail deposit decrease, then the financial frictions would have mattered less, because the banks now face less loan demand and the funding substitution is less necessary. Specifically, we compare large and small local banks funding substitution activity within banks with younger or older deposit-base, and examine how this differs across the groups. In our baseline result in Section 3.1.1, we found that larger banks are more likely to substitute retail deposit outflows with wholesale funding, reflecting fewer financial frictions. Note that in the absence of financial frictions, we would not observe this difference between the groups. Our conjecture is that financial frictions would matter more in a region with greater retail deposit outflows (i.e., a young deposit-base), because in those regions, the incentives for funding substitutions would be greater. Thus, we test whether the difference in funding substitution activity (to monetary stance change) across the bank size groups is larger when facing younger 22